Housing tilting economy down

The worst housing slump since World War II is showing no sign of abating. Manufacturing activity is hinting at recession. Employment is weakening. The Standard & Poor's 500 has dropped about 4 percent during the last week. The mistakes banks and brokers made with mortgage-related bonds have left a lingering credit crunch, or a reluctance by lenders to make affordable loans to consumers and businesses.

Investors have gone into the new year with a dreary attitude, and Wall Street analysts are warning investors to be careful.

"Batten down the hatches," Lehman Brothers economist Michelle Meyer said in a recent report.

Meyer estimates that the housing mess, which set off the economy's problems, is only half over, and that home prices will be down at least 15 percent when they hit bottom in 2009.

Only about 1.5 million of the most troubled mortgages, or adjustable-rate subprime loans, have reset to higher monthly payments so far. Meyer is expecting another 2.8 million in the next two years. With those resets, homeowners typically will have to pay about 30 percent more than they do now, a difficult nut for anyone, and especially for subprime borrowers, who were financially stressed in the first place.

To make matters worse, options are dwindling for the people who will be strapped. About half of the borrowers have less than 10 percent equity in their homes, said Meyer, and as foreclosures quadruple to about 1 million in both 2008 and 2009, the supply of discounted homes on the market will cause prices to fall further.

Of course, falling prices means dwindling equity in a home. So homeowners caught with a higher mortgage payment won't have the equity they need to refinance and escape. The result will be more foreclosures and more fire sales in an already glutted home market.

The questions hanging over the economy, and consequently the stock market, are: How badly will the housing mess spiral through the economy? Will homeowners feel poor and spend less? Will that crimp corporate profits and induce layoffs?

And as a new round of subprime-mortgage defaults strips the value out of mortgage-related bonds and loans held by banks and brokers, will that cut into their willingness to lend money to those who want or need it? Already, the financial institutions have been hobbled to some extent by $50 billion in write-downs.

The economy and investors might be about to get a lesson in manias similar to the early 2000s. Whether it is technology stocks or housing, people get carried away with excesses, miss the early warning signs and suffer the consequences.

Certainly, if this cycle turns out as bad as some imagine, analysts will look back at a plethora of warnings that should have been taken seriously.

Homeowners didn't have to overdose on mortgage debt they couldn't afford. Mortgage lenders didn't have to push poisonous adjustable-rate loans at homeowners when they knew the individuals couldn't afford them.

Wall Street investment banks didn't have to ignore the poison, while bundling the mess into the esoteric bonds that eventually would set off a credit crunch. Investors who bought the bonds didn't have to be as naive as the homeowners when they indulged, without question, in a financial product they didn't understand. Bond rating firms, which are supposed to safeguard investors by probing into the construction of bonds, didn't have to swallow Wall Street's numbers and give the toxic stuff a stamp of approval.

And Congress and banking regulators didn't have to ignore consumer advocates, who have been testifying for years that abusive mortgage-lending practices eventually were going to cause millions to lose their American dream.

Warnings of problems

Ironically, some of the early warnings came from within the investment banking firms that gained so much over the years creating bonds out of mortgage payments and then suffered recently as homeowners defaulted and the bonds plunged in value.

While not forecasting problems specifically for banks, Merrill Lynch economist David Rosenberg was among the economists sounding the early warnings. In September 2004, he said there was a clear housing bubble, and it could turn ugly.

In particular, he raised concerns about consumers overindulging in adjustable-rate mortgages, the loans that a few years later would cause a surge in defaults and undermine the value of the bonds Wall Street created.

When Rosenberg wrote his report, home prices in such markets as San Diego and Los Angeles already had climbed 80 percent, and Rosenberg described classic bubble characteristics: overheated prices, overownership, too much debt, speculation, complacency and denial.

He noted that subprime lending to people with lower credit scores and incomes had risen 25 percent on average throughout the decade, and that lenders could be at risk if people couldn't make payments or sell their homes in a weakening economy.

"About a third of first-time buyers," he said at the time, "have strapped on so much mortgage debt that roughly a third now pay at least 30 percent of their after-tax income on shelter, and half of the lowest-income households spend at least 50 percent of their income on housing."

Citigroup economist Steven Wieting raised similar concerns. And as ARMs became increasingly popular, Morgan Stanley economist Stephen Roach also referred to an "ominous surge in demand for adjustable-rate mortgages," especially among lower-income people who wouldn't be able to afford higher payments. Roach noted that from 2001 to 2003, ARMs amounted to about 20 percent of new mortgages, but by May 2004 half of the people getting loans were taking chances on them.

Meanwhile, Yale economist Robert Shiller emphasized to Barron's magazine that home buyers were making the dangerous assumption that "nothing beats a home as an investment because prices just keep rising."

While the economists were flashing warnings, consumer advocates also were busy asking Congress and the Federal Reserve to stop lenders from tantalizing homeowners with loans they would not be able to afford. They claimed that borrowers were not being warned about the monthly payments they would owe after resets, and that lenders were granting loans to people they knew couldn't handle the payments.

Mortgage brokers could make more money by putting people in subprime adjustable-rate mortgages rather than fixed-rate mortgages, said Eric Halperin, director of the Center for Responsible Lending. And borrowers often did not know they had cheaper, more attractive alternatives that would have saved them financial grief.

One Fannie Mae study estimated that 50 percent of subprime borrowers could have qualified for prime loans, which probably would have been more affordable for borrowers but less lucrative for lenders and mortgage bond investors.

The ARM lending craze set off a spiral of financial stress, said Kathleen Keest, senior policy counsel for the Center for Responsible Lending.

"Brokers would troll through lists to find people that were about to face a higher rate on their mortgage and then contacted them and offered a rescue," said Keest.

In fact, the new subprime loans were anything but a rescue. To get the loans, individuals often incurred thousands of dollars in fees that ate up their equity and put them on a collision course from the outset, she said.

As early as 1999 to 2000, consumer advocates were tracking what Keest calls a "foreclosure crisis," in which one in four homeowners were unable to handle payments.

"The industry wouldn't listen," she said.

With home prices rising, homeowners were able to refinance or sell homes when they couldn't afford mortgages. So the defaults didn't show up on the surface. The Center for Responsible Lending found them by digging through records. Wall Street and investors might have averted the credit crunch if they had done the same.

Government turned deaf ear

Despite numerous hearings, Congress and the Federal Reserve failed to adopt the protections that consumer advocates were requesting. Advocates say they ran into heavy lobbying by mortgage lenders and Wall Street firms involved in securitization, or the process of blending expected mortgage payments into the bonds that recently plunged in value, left banks with billions of dollars in write-downs and touched off a credit crunch.

In a House of Representatives hearing in November 2003 titled "Protecting Homeowners: Preventing Abusive Lending While Preserving Access to Credit," Cameron Cowan of the American Securitization Forum testified on behalf of the fast-growing $6.6 trillion industry.

By fabricating bonds from the payments people are expected to make on everything from credit cards to mortgages, he said, the industry was making it possible for more people to get loans at low prices. Cowan urged Congress to avoid regulation and also to stop state and local governments from measures aimed at curbing predatory lending.

The hearing, of course, occurred about four years before Wall Street's subprime-mortgage-related bonds turned into a debacle and a threat to banks and the economy. Cowan concluded his remarks at the hearing this way: "Regulation in this area could easily cause more harm than good."